Fiscal decisions about budgets, taxes and spending should be based on economic science, in much the same way that monetary policy has come to be science-based in recent decades, Indiana University economist Eric Leeper argues in a recent paper.

Leeper, a professor in the Department of Economics in the College of Arts and Sciences, says U.S. fiscal policy is "too political and too confused to be a player" in ensuring a strong economy. And fiscal confusion, he adds, threatens to undermine the effectiveness of monetary policy.

Photo by Ann Schertz

Eric Leeper

His paper, titled "Monetary Science, Fiscal Alchemy," was presented Aug. 27 at the 2010 Economic Policy Symposium in Jackson Hole, Wyo. The symposium was sponsored by the Federal Reserve Bank of Kansas City and attended by central bankers, policymakers and economists from around the world. Speakers included Federal Reserve Chairman Ben Bernanke and Jean-Claude Trichet, president of the European Central Bank.

Leeper, a former Federal Reserve System economist, says that he uses the terms "science" and "alchemy" to call attention to the generalization that "monetary policy tends to employ systematic analytics, while fiscal policy relies on unsystematic speculation."

In normal times, he says, fiscal alchemy doesn't seriously interfere with the ability of monetary policy to promote stable prices and sustainable economic output. But normal times may be coming to an end. With populations aging in the United States and most other G-20 countries, the costs of government pension and health-care programs are projected to increase exponentially. The situation portends an extended era of fiscal stress in which it will become increasingly difficult for consumers and businesses to make sound economic decisions.

"We need to be thinking very carefully and systematically about how to resolve the fiscal stress we're facing," Leeper said. "And the best way to do that is to subject policy decisions to scientific analysis."

But aren't fiscal decisions necessarily political and unscientific -- tied, as they are, to the creation of "winners and losers" through tax and spending policies?

"A lot of fiscal decisions should be made politically," Leeper said. "But there are some aspects of fiscal policy that are not so political, and for which decisions could probably be made outside the political realm."

He says fiscal issues could be divided into "micro" questions that remain subject to politics and "macro" questions on which nonpartisan agreement is possible. For example, research could provide a basis for agreement about a target ratio of government debt to gross domestic product and how the target should be achieved and maintained. Or about how much debt a government can support without markets deciding that the debt is too risky.

Leeper says central bankers can help by speaking out about the ways in which fiscal stress could hamstring monetary policy. And he suggests the creation of a fiscal policy council that would subject government decisions to independent scrutiny, an approach taken in Sweden and some other countries.

He argues that governments should fund research about the impact of fiscal policies. "There is a stunning and distressing lack of serious fiscal research conducted by fiscal authorities around the world," he writes. "Fiscal authorities need to invest in research, just as central banks have for decades."